Beruflich Dokumente
Kultur Dokumente
a balance sheet
SECOND (REVISED) EDITION
Publications of the International Labour Office enjoy copyright under Protocol 2 of the
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reproduction or translation, application should be made to the Publications Branch
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The International Labour Office welcomes such applications.
ISBN 92-2-103898-X
For permission to use copyright material in the preface and the glossary, grateful
acknowledgement is due to Hodder and Stoughton Ltd., publishers of Accounting reports
(London, 1970) by R.G.A. Boland and Di. Hall.
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The responsibility for opinions expressed in signed articles, studies and other
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Printed in Switzerland
CONTENTS
Technical data XI
Chapter I. Introduction
Set I. Some aspects of accounting I
Chapter 6. Profitability
Set 12. The profit and loss account 127
Set 13. Two measures of profitability 136
Set 14. The valuation of an enterprise 145
Appendix A
Technical note on inflation accounting 187
Appendix B
Glossary i
Panel A facing 20
Panel B facing 21
Panel C facing 48
Panel D facing 49
Panel E facing 92
Panel X facing 93
Panel F facing 140
Panel Y facing 149
VI
PREFACE TO THE SECOND
(REVISED) EDITION
Accounting has been called the language of business. The balance sheet
and the associated financial reports are the principal devices for
presenting information about the financial position of a private or public
enterprise. Training in accounting and financial management has
therefore had a prominent place in the Management Development
Programme of the International Labour Office (ILO) since the l960s,
when the first edition of this book was published. The book quickly
became avery popular training and self-development text, translated into
more than 20 languages and used in over 90 countries.
Although balance sheets are used throughout the world, their form and
the termsused in them vary from place to place according to national and
local customs and law. Furthermore, the interpretation of balance sheets
is directly related to the associated financial reports such as the profit and
loss account, the sources and uses of funds statement, the auditor's
certificate and the notes to the financial statements.
The subject is presented here in such a way that even people with limited
time for personal study will be able to master it easily. The programme
introduces the structure and language of a balance sheet (and of the
associated financial reports) and describes how the information given in
the various financial reports can be used to assess the financial position of
an enterprise. It also illustrates the structure of the resources of an
enterprise and explains the enterprise's responsibilities to, and relations
with, owners and other bodies.
public affairs at the local or national level. The growing emphasis on broad
consultation and on the popular understanding of development planning
may well extend the range of persons to whom such knowledge is useful,
especially now that enlightened enterprises in many countries provide a
considerable amount of information to their employees and to the
community.
Accounting language
Like any language, the language of accounting can never express our
thoughts with absolute precision and clarity. This language is complex and
many of the words used do not mean the same as they do in everyday life.
We must learn to think of the accounting, rather than the popular,
meaning of such words.
Uncertainty
Conservatism
Accounting practices, therefore, aim to take profits only when they are
reasonably certain and yet, by contrast, to provide for losses as soon as
they are known or anticipated. An attitude of conservatism, however,
could lead to mis-statement of the financial position of a business; hence,
generally accepted accounting standards try to present a "true and fair
view" of a business.
The basis of all profit is the accounting period during which the profit is
realised. Thus 10,000 units for a week is not the same as 10,000 units for
the whole year. Accounting figures are not significant in themselves but
only when they are compared with other figures for similar periods.
The accountant, therefore, despite the problems of uncertainty and
conservatism, tries to be consistent in his judgement so that the figures he
produces are comparable from one period to another.
Acknowledgements
x
TECHNICAL DATA
Type of programme
Linear — that is, the programme is to be done set by set and chapter by
chapter. Difficulties should be resolved by repeating the sets and by using
the glossary.
While you will work at your own pace, the results of our pilot tests
indicate that most people complete this programme (including the
mini-tests and the final quiz) in eight to 16 hours.
Testing
Appendices
Xl
HOW THE PROGRAMME
WORKS
I. Tear off the flap at the front of the book and use it as a mask to cover
the left-hand column of this page.
2. Read Frame A carefully and write the missing word in the last
column.
4. Then read Frame B and write the missing words in the right-hand
column, and so on.
5. Whenever you turn a page, mask the whole column at once and slide
the mask down only after you have written your answer in the last
column.
xlv
How the programme works
I
J. Where there are square brackets
one containing two or three words or
two words phrases, you should [choose the correct
more than two word or phrase/simply read them].
words
xv
How to read a balance sheet
IMPORTANT NOTE
Go on steadily set by set and never start a new set when you are
tired. Do not try to do too much in one sitting but make time
available to finish the whole programme over a few days; repeat it
as necessary.
xv!
PROGRESS WORK SHEET
Chapter I Set I 10 20
Set2 15 25
Study
glossary
Chapter 2 Set 3 25 50
Set4 25 50
Mini-test 20 20
Chapter 3 Set 5 20 39
Set6 5 35
Set7 5 30
Mini-test 20 20
Chapter 4 Set 8 30 64
Set9 20 45
Mini-test 20 20
ChapterS Set 10 25 40
SetlI 20 41
Mini-test 15 20
Chapter 6 Set 12 20 40
Set 13 20 50
Set 14 10 IS
Mini-test 20 20
Chapter 7 Set IS 25 52
Set 16 20 22
Mini-test 10 10
Final quiz 50 60
'If your English is not fluent, you may need to add up to I 00 per cent to each of the estimated
times.
XVII
INTRODUCTION I
Summary
There is no set of detailed rules that is universally agreed upon for drawing
up the financial statements of a business enterprise. As a result, balance
sheets of different business enterprises (especially if they are from
different countries) may differ in detail from each other. The basic
principles are always the same, however, and all balance sheets have
something in common.
IMPORTANT NOTE
2
introduction
3
How to read a balance sheet
4
Introduction
5
How to read a balance sheet
6
Introduction
Summary
The liabilities indicate what money has been made available to the
enterprise, and from where.
The assets show how the enterprise has used the money made available
to it.
Every balance sheet must include the name of the enterprise and the date
to which the figures in the balance sheet refer.
7
How to read a balance sheet
8
introduction
9
_______. _______.______.
_______ _______
l0
assets
liabilities HANDICRAFTS LTD.
Balance sheet at 31 December I 984
(expressed in "world currency units" (WCU))
ASSETS LIABILITIES
Raw materials, etc. 6 920 Bank overdraft 4 300
Land, buildings, etc. 17 500 Long-term mortage loan
owed to loan company 14 000
Money subscribed by
shareholders 6 120
Total assets Total liabilities
10
Introduction
l6
liabilities
assets
Balance sheet
(expressed in WCU)
ASSETS LIABILITIES
Raw materials, etc. 12 000 Bank overdraft 7 200
Land, buildings, etc. 20 800 Long-term mortage
loan owed to
loan company 10000
Money subscribed
by shareholders 15 600
Total assets 32 800 Total liabilities 32 800
II
How to read a balance sheet
18
name
date
HANDICRAFTS LTD.
Balance sheet at 31 December 1984
(expressed in WCU)
ASSETS L!ABILITIES
Raw materials, etc. 6 920 Bank overdraft 4 300
Land,buildings, etc. 17500 Long-term mortage
loan owed to
loan company 14000
Money subscribed
by shareholders 6120
Total assets 24420 Total liabilities 24420
12
Introduction
13
How to read a balance sheet
14
THE INVESTMENT SIDE OF 2
THE BALANCE SHEET ASSETS -
2. SET 3. TYPES OF ASSETS AND THEIR LIQUIDITY
Estimated time: 25 minutes
Summary
Fixed assets are acquired for long-term use in the enterprise, do not vary
greatly from day to day, and are only infrequently converted into cash
during the life of the enterprise.
Liquidity refers to the ease with which assets can be converted into cash;
thus, current assets are more liquid than fixed assets.
Those current assets that can be most quickly converted into cash are
known as quick assets.
Is
How to read a balance sheet
16
The investment side of the balance sheet — assets
(any two)
fixed
'7
How to read a balance sheet
18
The investment side of the balance sheet — assets
'9
How to read a balance sheet
20
PANEL A
Cash in banks
Cash in hand
Quick assets
(most liquid)
- Marketable securities (investments)
Customers' accounts (or debtors or
accounts receivable)
Deposits
Current assets Employee accounts (advances to
employees)
Other accounts outstanding
Prepaid expenses (rent paid in
- advance, etc.)
Finished products
Work in progress (semi-finished
- Inventories
products)
(or stocks)
Raw materials
Other supplies
— Land
Buildings
Fixed assets
Plant and machinery
(least liquid)
Fixtures and fittings
— Motor vehicles
PANEL B — overleaf
_______
PANEL B
ASSETS LIABILITIES
Current assets
Cash in banks — Owed to trade
Cash in hand 250 creditors, etc. 177 970
250
Marketable securities
(market value 2 100) 2000
Customers accounts 261 000
Deposits 550
Employee accounts I 200
Other accounts 3I5 Long-term loans 58 890
Prepaid expenses (rent
paid in advance, etc.,) 200
265 265
Less: Provision for
doubtful items I I 415
253 850
Inventories, at cost or
current market value,
whichever is the lower: Invested by
Finished products 30 500 shareholders 119740
Work in progress I 200
Raw materials 50 100
Other supplies 600
82400
Less: Provision for
inventory losses I 100
81 300
Total current assets 335 400
Fixed assets
Land, at cost I 600
Buildings, at cost II 000
Plant and machinery, at cost 8 800
Motor vehicle, at cost I 200
Fixtures and fittings, at cost 2 200
24 800
Less: Depreciation 4 600
20 200
Goodwill, at cost I 000
Total fixed assets 21 200
Total assets 356 600 Total liabilities 356 600
The in vestment side of the balance sheet — assets
FIXED
land
buildings
finished products
machinery
motor vehicles
fixtures and fittings
32 LIQUIDITY OF ASSETS
current 33! In theory all assets could be
sold converted into cash, though normally the
assets would not be sold to raise
cash.
2!
_______
FIXED ASSETS
(4) Land
Buildings
Plant and machinery
Fixtures and fittings
Motor vehicles
22
The investment side of the balance sheet — assets
40 QUICK ASSETS
cash in hand (I) 41. Current assets are more liquid than
marketable assets.
securities (2)
raw materials (3)
buildings (4)
23
How to read a balance sheet
24
______________________
Sum mary
Quick s —l
at cost or lower
Marketable securities
(most liquid) .5 realisable value
I
Deposits
LJ Prepaid expenses (e.g. rent)
]- at cost
I
Customers' accounts 1 at full value less
— Current assets
I
Employee accounts provision for doubtful
L Other accounts outstanding I items
Assets — F whichever is
(or stocks) Raw materials
I
the lower, less
L Other supplies I provision for losses
26
The investment side of the balance sheet — assets
27
How to read a balance sheet
28
The investment side of the balance sheet — assets
20 VALUATION OF INVENTORIES
foreign currency 21. Inventories, or stocks of finished
No! products, partly finished products, raw
materials, etc., are part of the
assets.
29
How to read a balance sheet
30
The investment side of the balance sheet — assets
3!
How to read a balance sheet
32
The investment side of the balance sheet — assets
40 41. Tosumup:forthepurposeofthe
cost balance sheet, land is generally valued at
depreciation .The other fixed assets are
valued at
33
How to read a balance sheet
34
The investment side of the balance sheet — assets
35
______________ _______
MINI-TEST ON CHAPTER 2
Now it is time to see how much you have learned. Answer the questions
below and, when you have finished, check your answers on the following
pages. Then enter the number you answered correctly on the Progress
Work Sheet.
2 A balance sheet always shows two main groups of figures, the assets
and the liabilities. The show what money has been made
available to the enterprise from different sources; the show
how this money has been employed.
37
How to read a balance sheet
I at a particular date.
2 liabilities; assets.
3 owned.
5 less.
6 are not.
9 current.
38
_______
_______
_______ _______
_______
_______
_______. _______
_______
Mini-test (cont.)
Quick assets are part of the assets. They include cash and
assets which can normally be
13 A balance sheet will usually show whether or not the management has
been in valuing the assets of the company.
39
How to read a balance sheet
Answers (cont.)
12 are not.
13 cautious.
I 6 sometimes.
I8 cost.
20 law.
40
THE FUNDING SIDE OF THE 3
BALANCE SHEET — LIABILITIES
3. SET 5. CURRENT LIABILITIES AND FIXED
LIABILITIES
Estimated time: 20 minutes
Summary
The shareholders are the owners of the company. On the balance sheet
the funds they provide are shown separately from those of "outsiders"
who have loaned money to the company.
Interest always has to be paid on bank loans, but most other current
liabilities do not require the payment of interest. Apart from bank
financing, then, current liabilities generally represent low-cost finance for
the company (unless cash discounts are lost).
41
How to read a balance sheet
IMPORTANT NOTE
42
The funding side of the balance sheet — liabilities
ASSETS LIABILITIES
Current assets Current liabilities
Fixed assets Fixed liabilities
Shareholders'
funds
Total Total
43
How to read a balance sheet
10 OUTSIDE LIABILITIES
outside II. Now look at the outside liabilities
current liabilities (the current and fixed liabilities) on the
fixed liabilities balance sheet in, Panel C. Both groups of
liabilities include amounts of money owed
to banks and other people. One group
does not have to be paid for a relatively
long time, while the other group may
have to be paid fairly quickly.
Which group of outside liabilities
would you say were the long-term
liabilities: current liabilities or fixed
liabilities?
44
The funding side of the balance sheet — liabilities
45
How to read a balance sheet
46
The funding side of the balance sheet — liabilities
.47
How to read a balance sheet
48
_______
PANEL C
ASSETS LIABILITIES
PANEL D — overleaf
PANEL D
ASSETS LIABILITIES
Summary
The money which the shareholders put into the company in this way is
described on the balance sheet as the capital issued.
49
How to read a balance sheet
50
The funding side of the balance sheet — liabilities
51
How to read a balance sheet
52
The funding side of the balance sheet — liabilities
to dividends.)
53
How to read a balance sheet
54
The funding side of the balance sheet — liabilities
55
How to read a balance sheet
Summary
The amounts on the balance sheet for earned surplus and capital surplus
do not reflect the amounts made during the year. Rather, they are the
cumulative totals for several years up to the date of the balance sheet.
However, a company may not need all the share capital it is authorised to
issue, and the company invites shareholders to contribute only as much
money as it actually needs. The amount actually contributed by the
shareholders is called the capital issued. It is always either less than or
equal to the capital authorised.
IMPORTANT NOTE
Thus, it is more correct to say that the balance sheet shows the
assets of a company and how the assets are financed from liabilities
and from shareholders' funds.
56
The funding side of the balance sheet — liabilities
57
How to read a balance sheet
58
The funding side of the balance sheet — liabilities
59
How to read a balance sheet
20
earned
capital
HOUSEHOLD UTENSILS LTD.
Balance sheet at 31 December 1983
(expressed in WCU)
ASSETS LIABILITIES
Current assets 335400 Current liabilities 178 860
Fixed assets 21 200 Fixed liabilities 58000
Shareholders' funds:
Capital authorised 200 000
Capital issued:
10 000 ordinary shares
of 10 money units each 100000
Capital surplus 8 440
Earned surplus II 300
Total shareholders' funds 119 740
Total assets 356 600 Total liabilities 356600
60
The funding side of the balance sheet — liabilities
.61
How to read a balance sheet
62
___________
_______
________ ________ ______________
_______
MINI-TEST ON CHAPTER 3
Now, see if you can complete this test on the material in Chapter 3. The
answers are on the following pages but do not look at them until you have
finished the test.
63
How to read a balance sheet
I liabilities.
5 short-term; current.
•6 current assets.
long.
9 fixed assets.
64
_______ _______
_______ _______
Mini-test (cont.)
IS A balance sheet should show not only how much capital has been
issued by a company, but also how much capital the company is
to issue.
65
How to read a balance sheet
Answers (cont.)
12 high.
13 low-cost.
14 ordinary shareholders.
I5 authorised.
i6 has not.
17 Incorrect.
19 shareholders' funds.
20 company or enterprise.
66
THE OVERALL .4
BALANCE SHEET
4. SET 8. FINANCIAL STRUCTURE
Estimated time: 30 minutes
Summary
By comparing the balance sheet figures for various groups of assets and
liabilities we can determine whether or not the company is 'solvent" and
"liquid".
the assets are financed by shareholders' funds and only one-fifth (20 per
cent) by borrowed money. By contrast a ratio of : 4 is high gearing
I
(high borrowing).
Always compare the current balance sheet figures with the previous
balance sheet to determine material (significant) changes and ask why
such changes have occurred.
Most published balance sheets give two sets of figures (for the current
year and for the previous year) to show how the current financial position
of the company compares with its previous financial position. A sources
and uses of funds statement based on such a comparison is also provided.
(The sources and uses of funds statement will be discussed in Set 9.)
IMPORTANT NOTE
67
______________'. _______________________
ASSETS LIABILITIES
Quick assets 180 Current liabilities 180
Inventories 200 Fixed liabilities 200
Land,building,plant,etc. lOO Total outside liabilities 380
— Shareholders' funds 100
68
The overall balance sheet
5
materials
assets SMITH MANUFACTURES LTD.
Balance sheet at 20 January 1984
(expressed in WCU)
69
How to read a balance sheet
70
The overall balance sheet
71
How to read a balance sheet
21 GEARING
working capital 22. Now let us compare the, share-
holders' funds at the end of 1983 with the
total finance employed by the company.
You can find the total finance employed
by an enterprise by looking at the figure
for the total assets or for the total
liabilities. Both these figures are the
since both sides of the •
l19,740x 100
= approx. 33 per cent,
356,600
at the end of 1983 the shareholders'
funds represented approximately one-
third of the total employed by
the company.
72
The overall balance sheet
73
How to read a balance sheet
I (figures).
74
The overall balance sheet
75
How to read a balance sheet
76
The overall balance sheet
54 55. Fromtheendofl983totheendof
40,974 1984 the gearing has gone down from
l:2to
77
How to read a balance sheet
78
The overall balance sheet
79
How to read a balance sheet
Summary
The sources and uses of funds statement shows the changes that have
taken place in the period between the two balance sheets in terms of new
funds available to the business and how they have been used; it shows
where new money has come from (sources) and how it has been used
(uses).
Depreciation is not exactly a source of new funds but it reduces the net
profit for the period. Since no money for depreciation actually leaves the
business, the source of funds is net profit before depreciation, which is the
same as net profit after depreciation, plus depreciation.
Sources of funds always equal uses. Any funds not used for the special
purposes above result in changes in net working capital (current assets
less current liabilities).
80
The overall balance sheet
IMPORTANT NOTE
The sources and uses of funds statement reveals the key financial
management decisions for the accounting period.
8!
How to read a balance sheet
82
The overall balance sheet
83
How to read a balance sheet
84
The overall balance sheet•
85
How to read a balance sheet
86
The overall balance sheet
87
How to read a balance sheet
88
The overall balance sheet
89
How to read a balance sheet
SOURCES OF FUNDS
Net profit for the period (after
depreciation charged) II 266
(a) (added back) 2 620
New share capital issued (b)
Total sources of new funds 33 886
USES OF FUNDS
Dividends paid 5 000
Purchase of fixed assets I 400
(c) in net working capital (d)
Total uses of new funds 33 886
90
The overall balance sheet
9!
How to read a balance sheet
92
______
PANEL E
ASSETS 3! Dec. 1983 3! Dec. 1984 LIABILITIES 31 Dec. 1983 31 Dec. 1984
PANEL X — overleaf
______ ______
PANEL X
ASSETS 31 Dec. 1983 31 Dec. 1984 L!AB!L!TIES 3! Dec. 1983 3! Dec. 1984
MINI-TEST ON CHAPTER 4
Now test yourself again. Check your answers and enter your results on
the Progress Work Sheet.
93
How to read a balance sheet
3 current liabilities.
4 25; high.
6 31 December 1983.
7 Yes. Because the total assets were greater than the outside
liabilities.
8 Yes. Because the current assets were greater than the current
liabilities.
9 Yes.
10 Yes.
94
_______
_______
_______
______________
Mini-test (cont.)
13 The main group of assets showing the biggest change was the
assets; which [increased/decreasedi from to
14 Fill in the missing figures in the following table of liabilities for Steel
Products Ltd.:
Current 29 Current 29
Fixed 24 Fixed 17
Shareholders' Shareholders'
funds 47 funds 54
Total 54 534 00 Total 50 629 100
20 A company whose total finance has increased from one balance sheet
to the next is always in a better financial position than one whose total
finance has not increased. True or false?
95
How to read a balance sheet
Answers (cont.)
l4 15,974 14,874
13,000 8,500
25,560 27,255
IS 984.
16 new.
17 source.
19 use.
20 False.
96
MEASURING SOLVENCY 5
AND LIQUIDITY
5. SET 10. SOLVENCY
Estimated time: 25 minutes
Summary
When the business expands, the solvency ratio may either increase or
decrease depending upon the source of funds to finance the expansion.
Similarly, it may. increase or decrease when the company contracts.
It is the gearing of the company which shows how assets are financed by
shareholders' funds (owners' equity) or outside liabilities.
A low solvency ratio (low shareholders' funds) indicates high gearing, high
risk and less potential for borrowing more outside finance (lower debt
capacity).
9.
_______
2
total assets
outside liabilities
ASSETS % LIABILITIES %
45
— Shareholders' funds 55
3. If we want to compare an
enterprise's degree of solvency at two
dates, it is helpful to use ratios or
percentages. Look at the above table of
assets and liabilities; they are expressed
here as percentages.
The "solvency ratio" is a useful
measure of solvency and it is very
often expressed as a percentage. The
percentage used is the difference
between the total assets and the outside
liabilities.
From the above table we can work
out that the solvency ratio is
per cent less per cent =
per cent.
98
Measuring solvency and liquidity
99
How to read a balance sheet
50
13
greater
total liabilities (or
total finance) COMPANY A
31 December 1982
ASSETS, % LIABILITIES %
100
_______________
I5
expansion
COMPANY A
LIABILITIES
lO I
How to read a balance sheet
2I
expanding
cOMPANY A
LIABILITIES
102
Measuring solvency and liquidity
103
_______ _______.
_______
25
increase
decrease
COMPANY B
LIABILITIES
104
Measuring solvency and liquidity
27
contraction
COMPANY B
LIABILITIES
los
How to read a balance sheet
31
expansion COMPANY C
solvency ratio LIABILITIES
106
Measuring solvency and liquidity
107
How to read a balance sheet
108
Measuring solvency and liquidity
Summary
The current ratio and the quick ratio are two measures of liquidity:
The current ratio measures general liquidity but the quick ratio measures
immediate liquidity.
If the current ratio is lower than I : I (e.g. 0.5 : I, which can also be
expressed as I : 2), current liabilities exceed current assets. This
generally shows that there is a high financial risk because, in business, cash
is more important than profit.
If the current ratio is too high (perhaps 3 : I or more) this may mean that
the company has more money than it can efficiently use. There is no hard
and fast rule about a ratio being too high, but when it rises continually
over time the situation should be examined.
109
How to read a balance sheet
•110
_______
_________ _______
9 current assets
10. Current ratio = :
liabilities current
assets
10 . quick
Quick ratio = :
liabilities current liabilities
assets
COMPANY D
ASSETS LIABILITIES
Quick assets I 000 Current liabilities I 000
Inventories 2 000 Fixed liabilities 5 000
Fixed assets 8 000 Shareholders' funds 5 000
Total I I 000 Total I I 000
liabilities
— 1,000÷2,000.
1—31
1,000
III
How to read a balance sheet
liabilities
— 1,000
I—I
1,000
liabilities.)
112
Measuring solvency and liquidity
, (figures)
113
How to read a balance sheet
I 14
_______ _______
_______
_______
36
finance ASSETS LIABILITIES
Current assets 14000 Current liabilities (average
Fixed assets 18000 interest: per cent)
I 2000
Fixed liabilities
(interest: 8 per cent) 13000
Shareholders' funds
(dividend: 10 percent) 17000
Total 32000 Total 32 000
115
How to read a balance sheet
116
________________ ________________
MINI-TEST ON CHAPTER 5
Now, how much have you remembered about this chapter as a whole? As
usual, do all the questions below and then check your answers,
ASSETS % LIABILITIES %
2 The solvency ratio indicates how easily an enterprise can meet its
out of its
Current liabilities
Bank overdraft 6000 4000
Others 4000
10000 28 4000 12
Fixed liabilities 12 000 34 12 000 34
Shareholders' funds:
Capital issued 10 000 16 000
Earned surplus 3 000 3 000
13000 38 19000 54
Total 35000 00 35000 100
117
How to read a balance sheet
I 36.
118
_______ ______________
_____________________
_______________
_______
_______
_______
Mini-test (cont.)
6 Look at the table of liabilities again. What are two reasons for the
change in the solvency ratio?
14 If the current ratio is very high this may mean that the of the
enterprise should be reorganised. A high current ratio may mean that
an enterprise has too much available.
I 5 Another reason for a high current ratio could be that the enter-
prise has too much [cheap/expensive] finance and not enough
[cheap/expensive] finance. The [current/quick] ratio gives the best
indication of ability to meet current liabilities at short notice.
119
How to read a balance sheet
Answers (cont.)
5 (2).
7 liquidity.
quick assets
I
current liabilities
I 2 current assets; current liabilities.
13 I : I; should.
120
______________
Mini-test (cont.)
Now pull out Panel X (page 93) and answer the following questions about
the liquidity of Steel Products Ltd. as at 31 December 1984.
• +
= .74:
•
• ÷
= .64:
•
20 From these quick ratios we can see that the were not
covered by the in either December 1983 or
December 1984.
12!
How to read a balance sheet
Answers (cont.)
23,609
16 1983:
15,974
23,727
17 1984:
14,874
191 + 11,626
18 1983:
15,974
190 ÷ 9,373
19 1984:
14,874
122
PROFITABILITY 6
Summary
A balance sheet shows assets and how they are financed at a particular
date; it needs to be supplemented by a document showing activity: sales,
costs, profit or loss made during the financial year to the date of the
balance sheet. Such a document, which is usually attached to the balance
sheet, is known as a profit and loss account (or income statement).
Four different types of profit are given in the profit and loss account:
gross profit, operating profit, profit before tax, and net profit after tax.
A company generally gets profits from the sale of goods and services.
Some of this money, however, has to be spent on raw materials, wages
and factory overhead costs for producing the goods and services. The
difference between the money received from sales and the costs directly
involved in producing the items sold (the cost of sales) is known as the
gross profit.
Thus: sales — cost of sales = gross profit (GP).
A business may incur further expenses not directly connected with its
day-to-day operations, e.g. interest payments on loans, purchase of
goodwill, losses on the sale of investments and fixed assets, etc. These are
termed "non-operating expenses".
Thus: operating profit — non-operating expenses = profIt before tax
(PBT).
123
How to read a balance sheet
124
Profitability
125
How to read a balance sheet
126
Profitability
127
How to read a balance sheet
28
Profitability
129
How to read a balance sheet
130
Profitability
'3'
How to read a balance sheet
Summary
profit interest on
before tax + fixed liabilities x 100
Return on total investment =
total investment
132
Profitability
133
How to read a balance sheet
134
Profitability
'35
How to read a balance sheet
shareholders' funds
fixed liabilities
return x 100
total investment
In other words, before tax +
interest on fixed liabilities x 100 is divided
by + fixed liabilities.
136
Profitability
.137
How to read a balance sheet
138
Profitability
'39
How to read a balance sheet
140
PANEL F
1983 1984
Operating expenses
Selling 27521 21328
Administration 18 090 10 512
General 4 980 4 873
50591 36713
Operating profit 16 960 20 741
1983 1984
141
How to read a balance sheet
Summary
If the business is to be wound up, we need to know how much cash will be
left when the assets have been sold and all the liabilities have been paid.
The balance sheet will not help us, because the fixed assets of a going
concern are valued at cost less accumulated depreciation; this may be
more or less than the realisable market value. Similarly, current assets are
valued at cost — or in the case of inventories at cost or market value,
whichever is the lower — in the ordinary course of business but not on
liquidation. Therefore, the balance sheet will not allow us to assess the net
worth of an enterprise that is to be wound up.
If the business is to continue as a going concern, the value of its assets will
be of less importance than its future profitability. In addition to past
performance, there are many factors not expressed in terms of money on
the balance sheet or profit and loss account that have an enormous effect
on the future profitability of the company. Some of these will be discussed
in Set 16, the final set.
142
Profitability
143
How to read a balance sheet
144
Profitability
145
_______ _______ ____________
_______________
_______________ _______
Profitability
MINI-TEST ON CHAPTER 6
Answer the questions below and when you have finished check your
answers on the Progress Work Sheet.
I Is it true that the balance sheet teUs us all that we need to know
about the financial position of a company or business enterprise?
9 Any of the net profits after tax not used in the payment of dividends
will be transferred to
+
12 Return on total investment =
+
147
How to read a balance sheet
I No.
2 during.
3 profits.
4 gross profit.
5 operating profit.
6 non-operating expenses.
8 after tax.
9 earned surplus.
10 management.
148
PANEL Y
Profitability
Mini-test (cant.)
Open out Panel Y: the balance sheet for Steel Products Ltd. at
3I December 1984 and the profit and loss account for 1983 and 1984.
1983:
+ )x 100= = percent.
) x 100 =
1984: + + = per cent.
x 100
1984: = = percent.
In other words, 1984 was [more/less] profitable than 1983 from the
shareholders' point of view.
17 When assessing the value of an enterprise, can we include the value of
the husband or wife of the accountant who always helps out with the
difficult figures?
18 The net worth of an enterprise that is to be wound up [can/cannot] be
assessed from the balance sheet.
19 When assessing the value of an enterprise as a going concern we need
to know both the net worth and the prospects of
149
How to read a balance sheet
Answers (cont.)
14 greater; reducing.
2,892 x l00_289,200
= 10.6 percent
27,255 — 27,255
More.
18 cannot.
19 future profitability.
20 Incorrect.
ISO
ASSESSING 7
THE BALANCE SHEET
7. SET IS. RELIABILITY
Estimated time: 25 minutes
Summary
A balance sheet offers useful information but how can we determine that
the data are reliable? We must check the internal consistency of the
balance sheet with the associated financial statements: the profit and loss
account, the sources and uses of funds statement, the auditor's certificate
and the notes to the financial statements.
'5!
How to read a balance sheet
IMPORTANT NOTE
The key to the balance sheet may often be found in the auditors
certificate and the notes to the financial statements.
152
_______
______
2
sheet
ASSETS LIABILITIES
Current assets 3 480 Current liabilities 2 870
Fixed assets 10 490 Fixed liabilities 4 350
Shareholders' funds 6 750
Total assets 13 970 Total liabilities 13 970
153
_______________
6
name of the
company
date
ASSETS LIABILITIES
Manufacturing tools Bank overdraft and
and stocks mortgage loan 50 600
of raw materials I 8 000 Accounts payable 8700
Land, buildings and Capital issued, earned
marketable securities 80 400 surplus, and loan
Finished products, from development bank,
customers' accounts repayable 1988 80900
and goodwill 41 800
Total assets 140 200 Total liabilities 140 200
154
Assessing the balance sheet
'55
How to read a balance sheet
156
Assessing the balance sheet
•1 S.
How to read a balance sheet
158
_______ _______
_______
_______
_______.
_______
159
How to read a balance sheet
160
Assessing the balance sheet
itself.
reduced in value.
161
How to read a balance sheet
162
Assessing the balance sheet
Summary
The balance sheet is also limited because the figures which appear on it are
only estimates and not scientific facts. The key accounting concept is not
absolute accuracy but rather materiality; it is very difficult to value assets
exactly. Furthermore, unless special inflation accounting techniques are
adopted (see the technical note in Appendix A), a balance sheet assumes
that the value of money remains unchanged over time, which is certainly
not true.
Always study carefully the profit and loss account, the sources and uses of
funds statement, the notes to the financial statements and the auditor's
certificate. Determine if the auditor was professionally qualified, inde-
pendent, and adequately paid to complete a professional audit; check that
the auditor was able to complete the audit within six months of the end of
the financial year.
163
How to read a balance sheet
164
Assessing the balance sheet
165
How to read a balance sheet
allowance for
166
Assessing the balance sheet
167
_______
_______ _______ _______
_______
_______
_______ _______
_______
MINI-TEST ON CHAPTER 7
Answer the questions below. When you have finished, check your
answers, and fill in the Progress Work Sheet as usual.
2 To help you decide about the acceptability of a balance sheet, you can
look at the balance sheet itself to see:
(a) whether it shows the of the company;
(b) whether it gives the of the balance sheet;
(c) whether it is set out in such a way that it is possible to work out
the values of the different classes of and
(d) whether it indicates the basis of the of the assets;
(e) whether there is a certificate from a professionally qualified
6 A second limitation is that the values shown on the balance sheet for
some of the [assets/liabilities] will never be exact.
7 Thirdly, a balance sheet often assumes that the real value of money
8 On the basis of the balance sheet, can you judge how successful an
enterprise will be in the future?
9 The auditor should be p qualified, i , and adequately
p
169
How to read a balance sheet
I. cautious reliable.
2 (a) name;
(b) date;
(c) assets; liabilities;
(d) valuation;
(e) auditor;
(f) directors.
4 law.
6 assets.
7 remains constant.
8 No.
10 notes.
6 or more correct Excellent. Now read all the summaries and the
glossary in Appendix B before trying the final
quiz.
4 or 5 correct? Read through the summaries of Sets 15 and 16
once more before going on to the final quiz.
Fewer than 4 Take a good break and then work through these
correct? last two sets once more.
I 70
FINAL QUIZ
The following questions test the knowledge you have acquired from the
programme. Tick the most correct answer in each case.
5 Those items which a company owns and which consist of cash and
things that will normally be converted into cash during the operating
cycle of the business are known as:
0 (a) current assets
o (b) current liabilities
El (c) fixed liabilities
0 (d) fixed assets
'7'
How to read a balance sheet
6 Assets which can be quickly converted into cash are known as:
o (a) shareholders' funds
o (b) unstable
o (c) quick liabilities
o (d) quick assets
7 Land and buildings, plant and machinery, fixtures and fittings and
motor vehicles all form part of a company's:
LI (a) current assets
o (b) fixed assets
o (c) quick assets
LI (d) liquid assets
8 Raw materials and work in progress form part of a company's:
o (a) current assets
LI (b) fixed liabilities
LI (c) quick assets
o (d) current liabilities
9 Which of the following do not form part of a company's assets?
LI (a) stocks of unfinished goods
D (b) shareholders' funds
LI (c) employee accounts
o (d) motor vehicles
10 Customers' accounts, employee accounts and other accounts out-
standing are usually valued at:
LI (a) the amount owed to the enterprise less provision for doubtful
items
o (b) the amount owed to the enterprise less depreciation
LI (c) cost + 10 per cent
LI (d) cost or current market value, whichever is the lower
Which group of assets would normally be valued at cost or current
I
172
Final quiz
12 Which of the following assets are not normally valued at cost less
depreciation?
LI (a) motor vehicles
o (b) plant and machinery
LI (c) buildings
o (d) investments
'73
______
'74
Final quiz
175
_______ _______
I 76
Final quiz
ASSETS % LIABILITIES %
Current assets 49 Current liabilities 25
Fixed assets 5I Fixed liabilities IS
Shareholders' funds 60
Total assets 100 Total liabilities IOU
38 If the solvency ratio has increased, this means that the excess of
_______ assets over outside liabilities has increased.
o (a) total
LI (b) current
o (c) fixed
0 (d) outside
177
_______
current liabilities
El (a) mobile assets
o (b) fixed liabilities
o (c) quick assets
o (d) quick liabilities
41 The current ratio and the quick ratio are measures of:
El (a) solvency
El (b) liquidity
0 (c) management pressures
0 (d) gearing
42 Which of the following is the best indicator of how easily a company
can meet its current liabilities at short notice?
D (a) current ratio
El (b) solvency ratio
El (c) net profit after tax
o (cI) quick ratio
43 A company has current assets of 100 WCU, quick assets of 30 WCU,
and current liabilities of 150 WCU. The current ratio is:
El (a) 1.5:
El (b) 0.67 :
El (c) 0.2 :
El (d) impossible to work out from the given figures
I 78
Final quiz
46 Which of the following are not deducted from the gross income from
sales in calculating a company's operating profit?
LI (a) cost of raw materials used in the goods sold
LI (b) wages of workers producing the goods sold
LI (c) wages of office staff handling accounts
LI (d) interest on mortgage loan on factory premises
47 Any of the net profit after tax left over after payment of dividends
is:
LI (a) used to pay wages of any non-salaried staff employed
LI (b) used to repay any long-term loans outstanding
LI (c) included in earned surplus
LI (d) included in capital surplus
'79
How to read a balance sheet
180
Final quiz
18!
How to read a balance sheet
82
Final quiz
I83
APPENDIX A
First read the introductory section. Then study each example carefully.
You will find an explanation of the figures in the explanatory notes.
Inflation
For instance, in Example B the profit and loss account shows a profit of
200 WCU which may have encouraged management to pay a dividend of
100 WCU for the year. However, when adjusted for inflation, the profit
of 200 WCU becomes a loss of 83 WCU. Thus, the dividend of 00 WCU
reduces the equity base (shareholders' funds) and the financial working
capital of the company.
Problems
185
How to read a balance sheet
For GPPA, all the items in a financial statement are calculated at a constant
monetary value using a general price index provided by the government
statistics office. Thus:
(a) the cost of fixed assets is adjusted for price changes from the date of
purchase to the date of the balance sheet; and depreciation is
calculated on the basis of the adjusted fixed asset cost;
(b) the opening and closing inventories are adjusted for price changes
from the date of purchase and the cost of goods sold is adjusted
accordingly;
(c) all profit and loss account items (other than cost of sales and
depreciation above) are adjusted to current price levels;
(d) the net monetary working capital (debtors less creditors) is adjusted
for price-level changes during the year.
The technique for these adjustments is objective but the general price
index may not reflect the real changes in fixed assets or inventory costs;
thus, GPPA adjustment may not reflect real profitability changes.
Furthermore, the GPPA depreciation charges may not provide for
replacement of fixed assets; accordingly, the financial statements
produced may be misleading and of little value.
186
Appendix A
Countries with high inflation (over 30 per cent per year) have introduced
a variety of measures to reduce the tax burden on inflationary profits;
however, where such tax laws differ significantly from generally accepted
accounting principles, the value of the resulting profit and loss accounts
and balance sheets is questionable.
For internal financial reports where inflation is high (over 30 per cent
per year), traditional standard costing and budgetary control systems
become less useful because they are based on the false assumption of
constant price levels. This affects many internal management decisions,
particularly those based on evaluating profitability and the financing of
working capital needs.
Conclusion
187
How to read a balance sheet
Example A
BALANCE SHEET
/983 1983
Historical cost Current cost
ASSETS
Fixed assets
Cost/valuation 800 I 466
Less: Accumulated depreciation 280 533
520 933 (Ex. 0)
Current assets
Cash 100 100
Accounts receivable 500 500
Inventory 400 500 (Ex. H)
1000 1100
Total assets 1520 2033
LIABILITIES AND OWNERS'
EQUITY (shareholders' funds)
Current liabilities
Accounts payable 400 400
Fixed liabilities
Long-term loan 520 520
Owners' equity
Capital 100 100
Revaluation reserve 796 (Note)
Earned surplus 500 217 (Ex. B)
600 1113
Total liabilities and owners' equity 1520 2033
188
Appendix A
Explanatory notes
I. The balance sheet shows how the total assets increase from 1,520 to
2,033 because the company revalued fixed assets (520 to 933) and
the inventory (400 to 500).
2. Earned surplus is reduced by 283 (Example B) (from 500 to 217)
due to inflation adjustments.
3. Revaluation reserve is increased from 0 to 796 which consists of
revalued fixed assets 413 (Example D) and inventory 100 (Example
H), and profit and loss accounts adjustments 283 (Example G).
189
How to read a balance sheet
Example B
1983 1983
Historical cost Current cost
Sales 2 500 2 500
Cost of sales 800 1800
Gross profit 700 700
190
Appendix A
Explanatory notes
I. The profIt and loss account shows how the profit of 200 is reduced to
a loss of (83) by CCA adjustments:
Depreciation increase 133 (Ex. D)
Cost of sales increase 250 (Ex. E)
Monetary working capital increase 20 (Ex. F)
Subtotal 403
Less: Gearing adjustment-offset of inflationary
losses by the debt: equity (long-term liabilities:
shareholders' funds) structure 120 (Ex. G)
Net CCA adjustment (above) 283
2. The closing balance of the statement of earned surplus is reduced
from 500 to 217 by the CCA adjustment of 283.
Example C
PRICE INDICES
1982 1983
End of Average End of Average
year year
Equipment 250 200 400 300
Materials 200 200 500 400
General price level 270 100 300 200
Explanatory notes
I. These price indices for equipment, materials and general price
changes for the years (982 and 1983 showing indices at the end of the
year and average indices.
2. The indices come from government statistical reports and are used to
adjust historical costs to current costs in Examples D to H.
3. Assumptions have been made so that only the end-of-year and
average indices for each year are used. However, other more
complex assumptions could be made.
191
How to read a balance sheet
Example D
192
Appendix A
Explanatory notes
I. The adjustment of fixed assets shows how the net book value of fixed
assets 520 (800 less 280) is increased by revaluation of 413 to a net
book value of 933 (1,466—533) (see 4(c) below); it also shows how
depreciation for the year is increased by I 33 (293 — 160) (see 4 (d)
below).
2. Depreciation is computed as 20 per cent per year.
3. The indices come from Example C.
4. The detailed adjustments for CCA are:
(a) 1982 purchases — Cost:
400 (end 83)
600 (HC) x = I 200 (CC)
200 (average 82)
Accumulated depreciation:
Accumulated depreciation:
400 (end 83)
40 (HC) x = 53 (CC)
300 (average 83)
193
How to read a balance sheet
Example E
Historical cost
Closing inventory 500 (HC)
Opening inventory (previous balance sheet) ISO (HC)
Total increase (included in the calculation of
the cost of sales) 350 (HC)
Explanatory note
The cost of sales adjustment shows how the increase in inventory of 350
(500— I 50) is analysed into a volume increase of 100 and a price increase
of 250. This price increase of 250 is due to inflation and therefore is
adjusted on the income statement (Example B) as an inflationary
effect.
'94
Appendix A
Example F
Explanatory note
The monetary working capital adjustment shows how the net credit
allowed has increased during the year to 100 (500—400) from 50 (on the
previous balance sheet). This increase of 50 is analysed as a volume
increase of 30 and a price increase of 20. The price increase of 20 is due to
inflation and is adjusted on the profit and loss account (Example B) as an
inflationary effect.
195
How to read a balance sheet
Example G
GEARING ADJUSTMENT
Liabilities
Long-term loan 520 (Ex. A)
Less: Cash IOU (Ex. A)
Net long-term liability financing 420
196
Appendix A
Explanatory notes
I. The gearing adjustment shows how financing net assets with long-
term debt (420) rather than equity (I, 113) (i.e. with long-term
liabilities rather than shareholders' funds) enables the company to
pass on part (30 per cent) of the inflationary loss to long-term
creditors.
2. In this case the gearing effect shows how the debt : equity (long-term
liabilities
: shareholders' funds) structure (420 I 113) of the
,
197
How to read a balance sheet
Example H
INVENTORY ADJUSTMENT
Explanatory note
The inventory adjustment shows how the 1983 closing inventory of 400
valued at average cost for the year is revalued with year-end indices
by 100 (500 — 400), which is credited to the revaluation reserve
(Example A).
198
APPENDIX B
GLOSSARY
The glossary includes terms used in this book and other accounting
language which you might come across in the course of your work.
Alternative expressions are given in parentheses after the main entry.
accounting the technique of preparing financial statements from bookkeeping
records (based on accounting concepts such as those given below).
accounting concepts (accounting principles) practical rules which enable bookkeeping records
of transactions to be converted into financial statements. The rules
include concepts of cost, consistency, conservatism, comparability, going
concern, accounting period, matching, profit realisation, materiality, etc.
accounts payable (creditors) money owed by a business. Accounts payable appear on the
balance sheet under current liabilities.
accounting period the time interval from the date of one balance sheet to the next. The
period of the profit and loss account (usually one year).
accounts receivable (see customers' accounts)
accrual (liability, creditor, payable, current liability) an accounting concept:
income and expense for the accounting period, whether for cash or
credit, must be included. Revenues must be matched with appropriate
expenses to provide a meaningful net income figure for an accounting
period, regardless of when cash may have been exchanged.
accumulated a total amount by which the original cost of a fixed asset shown on the
depreciation balance sheet has been reduced to take into account deterioration and
obsolescence. For example, consider a water works that costs millionI
'99
How to read a balance sheet
200
Appendix B
201
How to read a balance sheet
cost concept an accounting concept: assets are valued at cost not at market value.
Exceptions: (a) fixed assets are valued at cost less depreciation; (b)
current assets are normally valued at cost or market value, whichever is
the lower.
cost of goods sold (see cost of sales)
cost of sales the cost of the goods actually sold during the accounting period. It
excludes the cost of goods left unsold and all overheads except
manufacturing overheads. The cost of sales appears in the profit and loss
account. Sales less cost of sales equals gross profit.
creative accounting (see manipulation) a polite term for manipulation.
creditor (see accounts payable) a person or company who has supplied goods or
services but who has not yet been paid for them.
credit transaction a transaction which incurs (accrues) liability. No cash is paid or received
until later.
cumulative preference shares whose unpaid dividends accumulate until they are
preference shares eventually paid by the company. Some preference shares are specifically
non-cumulative.
current assets assets which are normally realised in cash or used up in operations during
one accounting period, normally one year. Current assets include cash,
debtors, inventory and prepaid expenses but not fixed assets or other
assets.
current liability a liability due for payment within one operating period, normally one
year. This does not include long-term liabilities or shareholders' funds.
current tax liability current liability for income tax which is due within one year (see also
future income tax liability).
current ratio ratio of current assets divided by current liabilities. A measure of
liquidity.
customers' accounts (accounts receivable, debtors) money owed to a business. Customers'
accounts appear on the balance sheet under current assets.
days of payables (see ratios)
days of receivables (see ratios)
debentures (see bonds)
debt capacity potential for borrowing more outside finance (related to gearing).
debtor (see accounts receivable) someone who has received goods or services
but has not yet paid for them.
deferred shares (deferred stock) shares of a company ranking for dividend after
preference and ordinary shares.
202
Appendix B
depreciation the reduction of the original cost of a fixed asset by a certain amount each
year over its working life. The amount is charged as an expense in the
profit and loss account. Land does not depreciate (see also accumulated
depreciation, depreciation expense, straight line depreciation and
diminishing balance depreciation).
depreciation depreciation (at cost) during the accounting period. This is not the same
expense as accumulated depreciation except in the first year of the fixed asset.
diminishing balance a method of depreciation which charges off the cost of a fixed asset by a
depreciation level percentage of the reducing balance over its working life. The
percentage remains the same but the depreciation charge decreases.
direct costs costs conveniently associated with a unit of product. Normally direct
labour, direct material, direct services (e.g. hire of equipment for one
specific job). All other costs are indirect costs, known as overhead
expenses. (Some cost accountants also use the term "direct" for specific
costs, i.e. overhead expenses which are clearly identifiable with an
overhead cost centre but not with a unit of product.)
director the officer of a limited company. A member of the board of directors. Not
a "partner".
discount (see cash discount, trade discount)
dividends that part of the net profit set aside for payment to shareholders; not an
expense chargeable in the calculation of net profit in the profit and loss
account; chargeable to the statement of earned surplus, it reduces the
balance of earned surplus declared by directors on the balance sheet. It is
not an automatic right of shareholders to receive dividends. A use of funds
(see sources and uses of funds statement).
downside risk risk of loss due to total business failure and subsequent liquidation of
assets to pay creditors and owners (see asset back-up).
dual aspect an accounting concept: two aspects of each transaction; the basis of
double-entry bookkeeping; debit and credit.
earned surplus (retained earnings, accumulated profit) the earned surplus available for
the payment of dividends. Part of the shareholders' funds.
earnings (income, profit, revenue)
entity an accounting concept: financial statements are prepared for a specific
entity. A shopkeeper, who personally owns his business premises, has
three entities and rewards:
203
How to read a balance sheet
204
Appendix B
fixtures and fittings miscellaneous office furniture and equipment. Such items are classed as
fixed assets if they are acquired for use and not for resale.
funds flow (see sources and uses of funds statement)
statement
future tax liability reserve for future income tax. Tax computed on the current year's profit
not due for payment until a future date. This normally becomes the
current tax liability in the following year.
gearing the ratio of shareholders' funds to borrowed money (4 : I means 20 per
cent borrowed (which is low); : 4 means 80 per cent borrowed (which
I
income (earnings, profit, revenue) this is sometimes used to mean sales and all
forms of incoming benefits, not necessarily in cash. Money, or money
equivalent, earned or accrued in an accounting period.
income statement (see profit and loss account)
income tax liability (see current tax liability and future tax liability)
205
How to read a balance sheet
inflation accounting technique for adjusting normal (historical) financial statements according
to changes in price levels (see Appendix A).
intangible asset an asset which cannot be physically touched (may be shown separately or
as part of the fixed assets). Goodwill and patents are examples of
intangible assets.
investment amount invested in stocks, shares, bonds, debentures or any asset (see
also trade investments, marketable securities).
inventory stock of goods (including supplies) available for resale. Inventory is
valued at cost or market value, whichever is the lower, not at selling price.
Increased by purchases. Decreased by cost of sales. On the balance sheet
it appears as a current asset, not as a fixed asset.
issued capital (see capital issued)
issue price of a the price at which stock is first sold by a company.
share
206
Appendix B
current assets
current ratio = :
current liabilities
or the
quick assets
quick ratio = :
current liabilities
long-term liabilities (see fixed liabilities)
loss (deficit) the opposite of profit or income. Excess of costs and expenses over
income or sales. A loss reduces the shareholders' funds but may not affect
the cash balance.
loss on disposal of loss due to sale or disposal of fixed assets. Excess of fixed asset cost over
fixed assets accumulated depreciation, and scrap or sale proceeds. Treated as "other
income and expense" in the profit and loss account. Significant losses or
profits are sometimes charged to capital surplus.
machinery a fixed asset if acquired for use and not for resale. Machinery is valued at
cost less depreciation. Machinery manufactured or acquired for resale is
classed as inventory.
manipulation changes in values of assets and liabilities, using generally accepted
accounting principles, to produce higher or lower profit levels
(sometimes referred to as "creative accounting").
manufacturing overheads for manufacturing. Part of the cost of sales. It is not a sales or
expense an administrative expense.
marketable quick assets; investments easily converted into cash.
securities
materiality a key accounting concept whereby only "material" amounts are
important, and "non-material" amounts may be ignored. The concept
recognises that the balance sheet and associated financial statements are
only reasonable estimates and not scientific facts.
matching an accounting concept: costs and revenues in the accounting period
should be "matched" in order that the computed profit may be true and
fair. Matching means "appropriate to" not "equal to".
money an accounting concept: financial statements are limited because they can
only reveal facts about the business which can be expressed in monetary
terms.
mortgage long-term loan normally secured on fixed assets, usually property. A
mortgage is a long-term liability, not a current liability.
net this has two meanings: (a) figure after deduction (e.g. gross sales less
sales returns equals net sales); (b) payment of the full amount due with no
allowance for cash discount (e.g. 2½ per cent discount for payment
within ten days, net for payment within 30 days).
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How to read a balance sheet
net assets assets less liabilities (see also return on investment, shareholders'
funds).
net income (see net profit)
net profit (net income, net earnings) profit for the accounting period after income
tax. The net profit increases shareholders' funds but does not necessarily
affect the cash balance.
net profit measures of profitability:
percentages
net profit
(a) net profit to sales: x 100 per cent
net sales
(b) net profit to shareholders' funds (return on investment):
net profit
x 100 per cent.
shareholders funds
Note: return on investment may appear to be high if the assets on the
balance sheet are significantly undervalued.
net worth assets less liabilities. The shareholders' funds (or owners' equity). The
balance sheet value of owners' claims based on accounting concepts. The
net worth does not indicate the market value of a business.
nominal value face (par) value of shares. Authorised and issued share capital on the
balance sheet shows the nominal value of the shares separately from any
premium or discount. The nominal value is not the book value or the
market value of shares.
non-operating expenses not directly related to normal operations, e.g. loss on sale of
expenses fixed assets, interest paid, etc. Significant losses are sometimes charged to
earned surplus or even to capital surplus.
non-operating income not arising from normal operations, e.g. profit on sale of fixed
income assets, dividends received, etc.
notes to the notes attached to the balance sheet and profit and loss account which
financial statements explain: (a) significant accounting adjustments; (b) information required
by law, if not disclosed in the financial statements; (c) changes in the
accounting concepts used to prepare the financial statements; (d)
exceptions to consistency with previous figures; (e) contingent liabilities;
(f) commitments. (Search here for evidence of manipulation.)
opening stock inventory at the beginning of the accounting period.
operating expenses all overheads of the business. Sometimes the term is restricted to mean
only selling, administrative and general expenses.
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Appendix B
operating profit gross profit less operating expenses in the profit and loss account.
ordinary shares part of the shareholders' funds on the balance sheet. Holders are entitled
to dividends recommended by the directors. Not preference shares.
Possible values: (a) face or nominal value; (b) market value; (c) issue
price (including any premium); (d) book value (total shareholders' funds
less the par value of preference shares) (see also deferred shares).
other assets assets which are not fixed assets or current assets. Normally: goodwill,
research expenditure carried forward, trade investments, etc. Other
assets are valued at cost, not at market value, unless losses are
exceptional.
other creditors creditors or accruals for services. Not trade creditors for the purchase of
material and supplies. Other creditors appear under current liabilities on
the balance sheet.
overhead expense (overhead) an indirect cost which may be fixed or variable according to
the volume of production (see manufacturing, sales and administrative or
general expenses).
owners' claims (see shareholders' funds)
owners' equity (see shareholders' funds)
par value (see nominal value)
patent legal right to exploit an invention. A patent is classed as an intangible asset
on the balance sheet; it is recorded at cost less depreciation.
payable (account payable, creditor)
plant equipment and machinery. This is classed as a fixed asset if acquired for
use and not for resale.
preference share a share which entitles the holder to fixed dividends (only) in preference
to the dividends for ordinary shares. On liquidation, holders are normally
entitled only to the par value. Holders have no right to share in excess
profits.
preference stock preference shares in units.
prepaid expense an expense paid in advance for more than one accounting period.
Examples are prepaid rent or taxes and unexpired insurance pre-
miums.
profit (income, earnings) excess of sales over costs and expenses during an
accounting period. Profit does not necessarily increase cash — it may be
reflected in increased assets or decreased liabilities — but it increases
owners' equity. The term "net profit" sometimes means profit less
income tax.
profit after tax net profit. Profit before tax, less income tax for the accounting period, in
the profit and loss account.
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How to read a balance sheet
profit before tax operating profit, less non-operating expenses, plus non-operating
income, in the profit and loss account. It is not net profit.
profit and loss (income statement) a statement showing sales, costs, expenses and profit
account for an accounting period.
profit and loss (see statement of earned surplus)
appropriation
account
profit realisation an accounting concept (see conservatism).
profitability (see net profit percentages)
provision this strictly means liability, but often has several different meanings:
(a) reserve, e.g. future income tax liability; (b) accumulation, i.e.
accumulated depreciation; (c) expense, e.g. depreciation expense;
(d) accrual, e.g. accrued expense, liability.
published financial balance sheet, profit and loss account, statement of earned surplus,
statements sources and uses of funds statement and notes to the financial statements,
with comparative figures and notes disclosing the information required by
law. They are less informative than internal statements (see also notes to
the financial statements).
quick assets cash, call loans, marketable securities, a commodity immediately saleable,
receivables. Quick assets are assets which can be made liquid in the
immediate future, such as within a month.
quick liabilities that part of the current liabilities that is due to be paid soon (e.g.
one month); not normally shown separately on the balance sheet.
quick ratio ratio of quick assets to current liabilities. A measure of immediate liquidity
(see gearing).
ratios useful indices of the financial health of an organisation. Healthy ratios are
developed from industry averages according to the size of the
organisation. Ratios include those for: (a) liquidity (quick ratio, current
ratio, solvency (gearing) ratio); (b) activity (assets. turnover
(sales/assets), inventory turnover (cost of days of
receivables ((receivables/sales) x 365 days), days of payables
(payables/cost of sales) x 365 days); (c) profitability (gross profit ratio,
net profit ratio, return on investment ratio).
receivable (account receivable, debtor)
recognition of profit an accounting concept: profit (income) is not recognised and recorded
until realised (in cash or debtors). By contrast, losses are recognised
immediately they are known. Profit is normally recognised when goods
are shipped to the customer, not when the order is received or when the
customer pays for the goods.
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Appendix B
reserve this is a vague term. Strictly it means earned surplus (see also capital
surplus, provision).
retained earnings (see earned surplus)
retained profit (see earned surplus)
return on financial ratios are:
investment , net profit x 100
(a) return on shareholders funds =
shareholders funds
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How to read a balance sheet
solvency ratio this is related to the gearing ratio; it is expressed as a percentage and it
shows the degree of risk. It may be measured in two ways:
shareholders' funds
(a) x 100 per cent
total assets
shareholders' funds
(b) x 100 per cent.
total assets less current liabilities
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Appendix B
transaction a business event recorded in the accounts; a change in two items on the
balance sheet (a cash or a credit transaction). A transaction may be a sale,
a purchase, a cash receipt, a cash payment or an accounting adjustment.
Translated into debits and credits in the bookkeeping records.
true and fair an accounting concept: the balance sheet and the profit and loss account
show a "true and fair view" of the business, in accordance with generally
accepted accounting principles.
uncertainty limitation of accounting. Uncertainty at the end of each accounting period
makes it difficult to determine the "true and fair" position. Uncertainty
arises from: (a) incomplete transactions; (b) the market value of
inventory; (c) the working life of fixed assets for depreciation cal-
culations; and (d) the realisable values of assets; and (e) contingent
liabilities not yet known or calculable.
unpaid dividends dividends declared as due to shareholders but not yet paid in cash. These
are shown as current liabilities on the balance sheet. They are deducted
from earned surplus in the shareholders' funds.
value this has several meanings: (a) accounting value — value according to
accounting concepts, appropriate to the particular asset. Fixed assets are
valued at cost less depreciation. Current assets are generally valued at
cost or market value, whichever is the lower; (b) market value — realisable
value of inventory in the normal course of business (not on liquidiation);
and (c) real value — not known in accounting.
working capital (net working capital) current assets less current liabilities. Working
capital is not the same as capital. "Monetary" working capital refers only
to cash, receivables and payables.
working capital ratio (see current ratio)
work in progress work partially completed. Part of inventory, stock. Valued at
manufacturing cost or market value, whichever is the lower.
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